Question

Better Mousetraps has developed a new trap. It can go into production for an initial investment in equipment of $5.4 million. The equipment will be depreciated straight line over 6 years to a value of zero, but in fact, it can be sold after 6 years for $682,000. The firm believes that working capital at each date must be maintained at a level of 10% of next year’s forecast sales. The firm estimates production costs equal to $1.30 per trap and believes that the traps can be sold for $5 each. Sales forecasts are given in the following table. The project will come to an end in 6 years. when the trap becomes technologically obsolete. The firm’s tax bracket is 35%, and the required rate of return on the project is 8%. Suppose the firm can cut its requirements for working capital in half by using better inventory control systems.

Sales Units millions of traps

0

0.5

0.7

0.8

0.8

0.7

0.5 Thereafter 0

By how much will this increase project NPV? (Enter your answer in millions round to 4 decimal places)

Answer 1

Year	CF	DF	PV
0	-5.65	1	-5.65
1	1.4175	0.925926	1.3125
2	1.9485	0.857339	1.670525
3	2.239	0.793832	1.77739
4	2.289	0.73503	1.682483
5	2.0985	0.680583	1.428204
6	2.2108	0.63017	1.393179
	NPV =     …..		3.6143

Increase in NPV due to acceptance of the give project = 3.6143 millions.

Explanation of cashflows

Year	0	1	2	3	4	5	6
Sales (in Million of units)	0	0.5	0.7	0.8	0.8	0.7	0.5
Sales (in Million of dollars)	0	2.5	3.5	4	4	3.5	2.5
(-) Cost of production	0	0.65	0.91	1.04	1.04	0.91	0.65
(-) Depreciation = 5.40 / 6 years	0	0.9	0.9	0.9	0.9	0.9	0.9
Earnings before tax	0	0.95	1.69	2.06	2.06	1.69	0.95
(-) Tax	0	0.3325	0.5915	0.721	0.721	0.5915	0.3325
Earnings after tax	0	0.6175	1.0985	1.339	1.339	1.0985	0.6175
(+) Depreciation	0	0.9	0.9	0.9	0.9	0.9	0.9
Annual cash Inflow		1.5175	1.9985	2.239	2.239	1.9985	1.5175
Working capital (cash outflow)	-0.25	-0.1	-0.05	0	0.05	0.1	0.25
Cost of equipment (outflow)	-5.4						0.4433
Net cash flow	-5.65	1.4175	1.9485	2.239	2.289	2.0985	2.2108

Sales in dollars is obtained by multiplying the units with $5 and cost of production is obtained by multiplying units with $1.30.

Working capital is calculated as 10% of subsequent year sales from which existing working capital is deducted to obtained to record the increase and decrease of working capital needed in that year. Increase is cash out flow and decrease is cash inflow.

Investment = 5.4 millions in Year - 0............... against this we received 0.682 million as sale of scrape. Asset is already depreciated to zero salvage so this receipt shall be taxable . Thus net of tax = 0.682 * 0.65 = 0.4433